Note on Equilibrium price and output determination under perfect competition

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Short run equilibrium

The short run is a period in which market supply cannot be varied according to change in market demand. It is due to lack of sufficient to vary units or capacity of all inputs. Under perfect competition, an industry is supposed to be a group of firms. When the industry reaches a state of equilibrium, the price of the product is determined. There are two conditions for the industry equilibrium. They are:

a) Market demand equal market supply

b) All firms are in equilibrium.

But under perfect competition, the firm should determine the level of output because it takes its price from the industry. The single firm under perfect competition is regarded as a price taker. The fact that a firm is in equilibrium does not necessarily mean that it makes excess profit. Whether the firm makes excess profit or losses depends on the efficiency of the firm and the level of average cost at the short run equilibrium. These three cases are:

  • If AR = AC, it implies firm obtain normal profit.
  • If AR > AC, it implies firm obtain excess profit (or supernormal profit)
  • If AR < AC, it implies firm incurs losses
Short run equlibrium
                                                Short run equilibrium

Suppose there are only three firms A, B, and C under a competitive industry. According to figure B, firm A is in equilibrium at a point E1. Thus,

Level of output = OQ1

Price per unit = OP

Total revenue = Area of OPE1Q1

Total cost = Area of OCbQ1

Here area of TR > Area of TC, thus firm A obtains excess profit.

According to figure C, firm B is in equilibrium at a point E2. Thus,

Level of output = OQ2

Price per unit = OP

Total revenue = Area of OPE2Q2

Total cost = Area of OCbQ2

Here area of TR = Area of TC, thus firm B obtains normal profit.

According to figure D, firm C is in equilibrium at a point E3. Thus,

Level of output = OQ3

Price per unit = OP

Total revenue = Area of OPE3Q3

Total cost = Area of OCbQ3

Here area of TR < Area of TC, thus firm C incurs losses.

 

In the long run

However, in the long run, firms are attracted into the industry if the incumbent firms are making supernormal profits. This is because there are no barriers to entry and because there is perfect knowledge. The effect of this entry into the industry is to shift the industry supply curve to the right, which drives down the price until the point where all super-normal profits are exhausted. If firms are making losses, they will leave the market as there are no exit barriers, and this will shift the industry supply to the left, which raises the price and enables those left in the market to derive normal profits.

 

Long run equilibrium

The long run is a period in which market supply can be adjusted according to change in market demand. It is due to the availability of sufficient to vary units or capacity of all inputs. Thus, in the long run, firms are in equilibrium when they have adjusted their plan so as to produce at the minimum point of their long run average cost curve, which is tangent ( at this point) to the demand curve (AR) defined by the market price. In the long run, the firm will be earning just normal profits which are included in the long-run average cost. It is due to the condition of perfect competition i.e. free entry and exit of the firms.

The super normal profit obtained in the short run by the firm turns as an inducement to enter the market for new firms, which increases or raises industry supply and until only normal profit is made, market price falls for all firms.

Long run equilibrium
                       Long run equilibrium
 

In the figure, the firm reach in equilibrium at A where a) MC = MR, b) Slope of MC > Slope of MR and c) AR = AC = P. Here, the area of TR (OPAQ) and the area of TC (OPAQ) are equal. Thus, the firm obtains normal profit producing the level of output OQ units. The firm is able to utilize the optimal capacity of its resources. It is shown by the equilibrium point A where long run average cost is minimum.

Benefits of the perfect competition

It can be claimed that perfect competition will harvest the following welfares or benefits:

  1. It is assumed that all sellers and buyers have perfect or complete knowledge of the condition of the market. So, there is no information leakage and failure
  2. Every firm is free to enter the market or to go out of it. Simply, no barriers or obstructed to entry and exist in the market.
  3. No firms can enjoy the monopoly power.
  4. Firms can only enjoy with normal profits.
  5. Investment in the advertisement is not necessary from the producers. Because there is perfect or complete knowledge and firms can sell all they can produce.
  6. A maximum possibility of the consumer surplus and economic welfare in the perfect competition.
  7. There is maximum productive as well as allocative efficiency in the perfect competition:
    • Allocative efficiency refers to the equilibrium point that will occur when P = MC
    • In the long run, equilibrium will occur at the output where MC = ATC, refers as productive efficiency.
  8. There are also various choices for consumers. It enhances the level of the consumer’s satisfaction.

 

How realistic is the model?

Very few markets or industries in the real world are perfectly competitive. For example, how homogeneous is the output of real firms, given that even the smallest of firms working in manufacturing or services try to differentiate their product.

The assumption that producers and consumers act rationally is questioned by behavioral economists, who have become increasingly influential over the last decade. Numerous experiments have demonstrated that decision-making often falls well short of what could be described as perfectly rational. Decision making can be biased and subject to the rule of thumb ‘guidance’ when consumers and producers are faced with complex situations.

Although unrealistic, it is still a useful model in two respects. Firstly, many primary and commodity markets, such as coffee and tea, exhibit many of the characteristics of perfect competition, such as the number of individual producers that exist, and their inability to influence market price. Secondly, for other markets in manufacturing and services, the model is a useful yardstick by which economists and regulators can evaluate levels of competition that exist in real markets.

 

Reference

Koutosoyianis, A (1979), Modern Microeconomics, London Macmillan

 

  • In the short run of perfect competition:
  1. If AR = AC, it implies firm obtain normal profit.
  2. If AR > AC, it implies firm obtain excess profit (or supernormal profit)
  3. If AR < AC, it implies firm incurs losses
  • In the long run, firm earns only normal profits. It is due to the condition of free entry and exit of firm
  • All competitive firms are optimum because they operate their plant optimal capacity.
  • All competitive firms are also price takers because they cannot influence on price due to product homogeneity and complete knowledge about market.

 

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